Nice Rally You Got There…

You could make a fairly long list of compelling reasons to distrust the rally in US equities.

Earnings wouldn’t be on that list. Not yet, anyway. So far, with more than half of S&P 500 companies reporting, dire predictions about margins, profits and guidance haven’t materialized.

Generally speaking, stock prices are a function of profits and rates. If earnings don’t play along with the recession story but bond yields do, that’s a recipe for counter-trend rallies, especially when benchmark indexes are dominated by long-duration growth stocks with massive revenue and earnings power.

So, why not “go with it,” so to speak? Well, from a fundamental perspective, the economy is decelerating and the American consumer, “resilient” or not, isn’t enamored with generationally high inflation and deeply negative real wage growth.

At this juncture, defending margins is almost purely a function of corporates’ ability to offset lower volumes and higher costs by raising prices to irritated consumers who, when they’re not frowning at higher prices in the grocery aisles, are on the clock, stocking those same shelves. That’s a problem for a number of reasons, not least of which is that it’s conducive to the dreaded wage-price spiral — just ask Q2’s scorching hot employment cost index.

For now, it looks like retailers will absorb the hit through discounts on consumer goods. Eventually, though, services spending could wane too, unless inflation recedes. You’re reminded that leisure and hospitality is where wage growth is running the hottest, so if spending decelerates there, the risk of profit erosion is particularly high.

Beyond the fundamentals (because when have those ever mattered?), recent gains for stocks were in no small part attributable to short covering of one sort or another. “Equities flows continue to be largely technical in nature, which for some reason almost adds to the consternation of feeling ‘left behind’ on this rally,” Nomura’s Charlie McElligott said, noting “more of the same” vis-à-vis “buying from systematics [and] Net $Delta being added in the options space,” as puts are sold and closed.

On the bank’s model, CTA signals for global equity benchmarks are either long or much less short than they were a month ago. The figure (below) gives you a sense of how systematic covering may have worked to accelerate rallies in stocks and bonds.

Going forward, vol control could take the systematic baton for equities as three-month realized (still perched in the 90%ile on a one-year lookback) catches down to trailing one-month (which has collapsed to just 57%ile).

Notwithstanding the potential for a material re-allocation from the vol control universe (contingent, of course, on a relatively well-behaved distribution of daily outcomes), you could argue that the impulse from systematic flows will abate. At the least, you might suggest a rally juiced by mechanical flows is a rally built on a shaky foundation, especially given the sheer number of prospective macro “shock-down” catalysts just waiting to “realize” — spot is one adverse Nord Stream headline away from gapping lower, which could destabilize newly comfortable long dealer gamma positioning, for example.

But perhaps the most compelling reason to distrust the rally is that it’s unpalatable for a Fed desperate to preserve gains made on the road to tighter financial conditions. I discussed this at length in “Jokes On Jay,” a piece Bloomberg predictably xeroxed less than 24 hours later. Katherine Greifeld’s reliably capable pen rescued their version from being a pitiable (not to mention expensive) facsimile.

“A dynamic in which surging stocks complicate the goal of subduing inflation is one reason giant rallies are rare in times of tightening,” Greifeld wrote. “While the Fed may be ambivalent about equities in general, the role of markets in mediating a real-world economic lever — financial conditions — means they are never completely out of mind.”

That’s where the problem is for bulls. The Fed doesn’t want this rally. The two-day gain for US shares on Wednesday and Thursday (i.e., the FOMC rally) was among the largest ever. The figure (below) provides some context.

Again, that’s counterproductive. Among the last things the Fed needs is a rekindled wealth effect through the equities channel.

“I think most would agree that the FOMC probably isn’t loving the market’s post-meeting response,” McElligott remarked. “It simply makes their job of taming inflation that much more challenging via the risk of resumed ‘animal spirits’ and looser financial conditions.”

In his latest, BofA’s Michael Hartnett called optimistic views about the Fed being “done by Thanksgiving” premature. “A neutral fed funds by definition is not a ‘tight’ fed funds,” he said. “Big stock rallies are unlikely to encourage a Fed pause.”

Hartnett cited a chart he uses often: The ratio of US private sector financial assets to GDP (figure above). The parabolic ascent observed in the wake of pandemic stimulus appears, in hindsight, as an inflationary bridge too far, paired, as it inadvertently was, with the sudden demise of myriad disinflationary dynamics which enabled monetary largesse over the past dozen years.

Should the rally extend — Hartnett suggested 4,400 on the S&P would discourage a Fed pause — look for officials to use speaking engagements (and television cameos) to push back against any perceived FCI easing “overshoots” between now and the September FOMC meeting.

That’s the biggest rally impediment. Buying now is tantamount to fighting the Fed. “Nice rally you got there. Shame if something happened to it.”

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9 thoughts on “Nice Rally You Got There…

  1. But with no meeting until September what can they do if the market ignores the talking heads and keeps rallying “

  2. The Fed has been very timid (so far) in reducing its balance sheet. In early May, the Fed stated it would reduce its balance sheet starting June 1 by adjusting the reinvestment amount of principal payments received from its maturing holdings. The “cap” on reduction over the first three months was stated at $47.5 billion per month ($30 billion of Treasury securities and $17.5 billion of agency debt/mbs) and then doubling to a cap of $95 billion per month starting the fourth month. After 8 weeks (June 1 to July 27), the Fed’s balance sheet on a weekly basis has gone down and up (so it appears its definitely reinvesting something) but the total reduction over this 8-week period is only ~$25 billion vs. the ~$95 billion stated cumulative cap over the first two months.

    Interesting to me that shortly after stating it would reduce by up to $47.5 billion per month, that it actually hasn’t come close to hitting that mark.

    1. It didn’t start on June 1. It started on June 15, when the first relevant securities matured. They can’t just push a button and say “There, QT starts.” That would be active selling, which they aren’t doing. With passive run off, they have to wait for securities to mature. So if you want to do the math on this, you need to go to the NY Fed’s website and find the actual maturity schedule for each month, identify the relevant bonds, break out which are Treasurys and which are MBS, then add up the par value and see what’s left over to determine what the reinvestment flow will be (i.e., what’s above the monthly cap). That’s straightforward with Treasurys and if you look at just the Treasury portfolio, you can see runoff clearly. On the MBS side, you have to think about prepayments vis-a-vis sharply higher mortgage rates and refi activity (or a lack thereof) — it’s not so straightforward. This is (one reason) why some observers favor active MBS selling. There also appears to be some manner of calendar delay with MBS — a one-month operational lag. Between that and slower prepayments, the MBS side isn’t amenable to simplistic interpretation

      1. Given the size of the balance sheet don’t they need active selloff? (Or is it just a known secret that they don’t intend on ever going back to pre GFC?)

        1. Oh, pre-GFC isn’t possible. That’s a total nonstarter. It’s not so much “known secret” as it is objective fact. “Ample reserves” regime maintenance, regulatory changes for banks, market structure, etc. rule that out. In other words: Nobody, not the Fed, not banks, not analysts and not economists, intends to return the balance sheet to pre-GFC levels. That isn’t in the plan.

          1. Thank you for replying and with candor. I know that the US has survived, even had a strong economy and society, despite a (large?) national debt (borrowing from our own citizens SocialSecurity) and perpetual budget deficit (borrowing against our growth and massive natural resources)… so I guess this mirroring bu the Fed is a similarly survivable artifact.

          2. Politicians and economists really need to be more honest with the public about the issues you mentioned, because the way you’re conceptualizing of the situation reflects political rhetoric and economic orthodoxy foisted on you more than it does reality. There’s no such thing as the “national debt.” Treasurys aren’t “debt.” They’re interest-bearing dollars. When a foreign government borrows in dollars, that’s debt. They can’t print dollars to repay it. This is why comparisons between, on one hand, the US/UK/Canada/Australia/Japan and, on the other, Italy, Greece, Spain and even Germany, are dubious. None of those countries can unilaterally issue euros. They aren’t monetary sovereigns. Of course, you can be a monetary sovereign with no foreign currency debt and still find yourself in a less-than-enviable position. But people want dollars. And pounds will work. So will yen. The Aussie and loonie can be desirable depending on the circumstances. And so on. America has an obligation to pay principal and interest in a currency that we, and we alone, have the authority to issue. That’s not “debt.” The idea that Social Security can “go broke” is a myth — a total canard. The only way for such things to happen is through political ineptitude or political spite. Anything that can be paid for or purchased in US dollars America can afford. Because we are US dollars. There are no US dollars without the US government. The notion that we “borrow” US dollars from other nations or that the government “sources” US dollars from taxpayers is false by definition. Where, exactly, does China get genuine US dollars to “loan” us and where, exactly, do you get genuine US dollars to pay your taxes? Did China discover a dollar mine somewhere? Sure, the Saudis can drill oil, sell it for dollars, then invest those dollars in interest-bearing dollars to generate still more dollars, but that’s not “sourcing” dollars. That’s sourcing oil and trading it for dollars which, one way or another, came from the US government. Same thing with taxes. Did you discover a natural spring in the mountains from which genuine dollars flow? Of course not. All of the dollars in the known universe originate from, or are otherwise controlled by, the US government. Just ask Russia, which isn’t allowed to have any anymore. I’m not trying to make a point about inflation here, I’m just reminding readers that we (all of us, myself included) speak in nonsense terms about the US national debt, Social Security and, really, just money in general. We do it all day, every day. Most of the time, in everyday conversation, nonsense terms are necessary otherwise we wouldn’t be able to communicate with each other. But when it comes to US lawmakers, both Republican and Democrat, they speak in nonsense terms about government finances in many cases because doing so allows them to make a political point. As for economists, if they admit the truth publicly, it raises existential questions about their profession. Ironically, MMT economists are the worst offenders — you couldn’t sell many books or score many TV cameos if, instead of pitching a new “theory,” you were merely explaining that, in reality, developed economies spend first and figure out ways to pretend the spending is “funded” later. “MMT” is just a description of business-as-usual government finance, sold to the public as a revolutionary lens through which to view the economy. As ever, I’m the bearer of bad news: Nothing is as exciting as it sounds. Nobody has any good ideas. And what financial tabloids dress up and sell as compelling conspiracy theories about the interplay between government, the Fed, markets and the economy, are really just humdrum charades that follow naturally from the maintenance of a fiat regime.

  3. I understand how my use of those terms triggered you. =)

    My nuance: inflation is the boundary (of our “borrowing from a currency we print”).

    US govt collected money from it’s workers and has promised to (re)pay them an amount via monthly retirement, so acting like a bank or trust.

    SSI mandatory withholdings take money out of circulation (usually from those who’d most spend it); when the US govt “borrows” from that and spends it while simultaneously printing money to fund previous commitments to SS beneficiaries it increases the money supply.
    So what I meant was: it seems like the US govt “borrowing and deficit spending”, or effectively inflation (especially post vietnam war and post Reagan), has not ruined us (and yes being the world’s reserve currency is an ace in the hole).
    So similarly the Fed having more virtual dollars (Treasuries it bought; placeholders for the bailout from our financial institions CDS ponzi that actually affected the world) won’t inflate us into ruin either.

    It’s a fine joke of US financial machinations that Oil countries and China receive dollars, then the US reduces the value of those dollars by “printing” more.

    Also, to your point of the origin of dollars, I don’t believe that economists nor politicians want to discuss the truth that unlike printed bills with serial numbers and counterfeiting measures, the Trillions everyone talks about are just 1s and 0s in a bunch of computers (and we got plenty more where that came from).

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